Steve Johnson's litmus test for disciplined investing

How I miss the old days of 2021...

Central banks were drunk on liquidity. Tech stocks were headed to the moon without any sign of turning a profit. You could even make a fortune on dud companies that happened to find their way into Reddit forums. 

Investing was easy. But those heady times are over - as they should be. Investing is hard once again. 

Finding winners at the right price in today's market requires a disciplined approach that can be applied all the way down the line, from portfolio construction to your weekly trades.  

In the latest episode of The Rules of Investing, Forager Funds CIO Steve Johnson discusses some of the key principles he uses to stick to his strategy throughout the market cycle. 

Defend your portfolio with oversold stocks

With a recession creeping closer, capital preservation is front of mind for investors. But how should one go about it? You could go into defensive stocks - now incredibly expensive and crowded trades. You could target large-cap quality, but again, very crowded. You could shift your money into gold, but that's a single commodity that carries a lot of concentration risk. 

Or you could do what a value investor always does - buy cheap. 

"The best way to preserve capital is to pay prices that are cheap enough," says Johnson. 

"If you can pay a price that's low enough, that the expectations are low enough, that can actually do a really good job of protecting your capital to start with."

The right time to sell

The old adage to buy low and sell high is perhaps finance's easiest concept to understand and yet, the hardest to execute. 

So rather than trying to pick bottoms and tops, Johnson believes that the most disciplined time to sell a stock is when it's no longer offering you your minimum rate of return into perpetuity. 

"Thinking that you're going to try and pick the top is where it gets really dangerous," he says. 

"So whatever style of investor you are, whatever your objective is - when that stock is no longer playing that role, it's time to move on from it." 

For Forager, trading in and out of stocks isn't a binary all-in, all-out pursuit.

"We'll have 5-7% of our portfolio in a stock when we think it's really cheap. And when it's the right sort of business and in that same stock, we might have a 2% weighting still when it's going well, but it's nowhere near as cheap as it was," Johnson says. 

So instead of waking up one day and deciding 'yep, today's the day we sell the lot', Forager will simply sell down the stock based on its valuation. 

High-risk, low weight

Diversification, the only free lunch in finance. It's without doubt the go-to risk mitigation strategy. 

Johnson's all about diversification, but he also manages risk through his portfolio weightings. 

The concept is simple. The higher the risk, the lower the weight it should make up in the portfolio. 

"In our Australian portfolio at the moment, we've got a couple of little FinTech stocks which I think have some chance of being worth four or five times where they're trading today. Wisr (ASX: WZR) and Plenti (ASX: PLT) are those two companies that are totally illiquid and they are very, very risky, so they have 1%," he explains.   

By contrast, RPMGlobal (ASX: RUL) is profitable and resilient, so makes up 7% of Forager's Aussie portfolio. 

Have a hit list

Markets move quickly. So it's easy to miss the window of opportunity when a company is oversold. 

The top value investors, including Forager, have a hit list of stocks that they like, barring their trading price. When the market oversells the company, they strike. 

"I had the research team writing up a lot of finished full research notes on companies that we'd like to own at the right price. I'm hopeful that in certain sectors in particular, there's a bit more pain to come here on the ASX," Johnson says. 

James Hardie (ASX: JHX) is top of that list. 

It's no surprise. JHX commands 80% of the US market, with the associated benefits of scale. 

"That's a really high-quality business that people are capable of getting very pessimistic about if this US housing market experiences a downturn. [But] they're also predicting that it recovers pretty quickly," Johnson explains. 

The litmus test

Models are all well and good, but they shouldn't constitute an investment thesis alone. 

Johnson applies a simple litmus test. 

"If you can't describe it on the back of an envelope, then it's too complicated and there are too many things that can go wrong with it," Johnson says. 

"You might have a spreadsheet and that spreadsheet might be right in terms of the amount of cash that the business is going to generate. But you need to put a lot of time and effort into the people that are running that business, the other owners of that business and the people that are on the board and what they are going to do with that cash flow."

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